Weighted Average Cost of Capital Definition

Weighted average cost of capital, defined as the overall cost of capital for all funding sources in a company, is used as commonly in private businesses as it is in public businesses. A company can raise its money from three sources: equity, debt, and preferred stock. The total cost of capital is defined as the weighted average of each of these costs.

Weighted Average Cost of Capital Meaning

Weighted average cost of capital means an expression of the overall requited return on the companys investment. It is useful for investors to see if projects or investments or purchases are worthwhile to undertake. It is equally as useful to see if the company can afford capital or to indicate which sources of capital will be more or less useful than others. It has also been explained as the minimum return a company can make to repay capital providers.

Weighted Average Cost of Capital Formula

The most popular method to calculate cost of capital is through using the Weighted Average Cost of Capital formula. WACC = Ke *(E/(D+E+PS)) + Kd*(D/(D+E+PS))*(1-T) + Kps*(PS/(D+E+PS)) Where Ke = cost of equity Kd = cost of debt Kps= cost of preferred stock E = market value of equity D = market value of debt PS= market value of preferred stock T = tax rate Ke reflects the riskiness of the equity investment in the company. Kd reflects the default risk of the company, and Kps reflects its intermediate standing in terms of risk between debt and equity. The weights of each of these components reflect their market value proportions and measure how the existing company is financed.

Weighted Average Cost of Capital Calculation

Weighted average cost of capital calculation, though sometimes complex, will yield very useful results. Example: a company finances its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%. The required rate of return of this company according to the WACC is: (70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3%

That means the required return on capital is 8.3%. A company pays 8.3% interest for every dollar it finances.

Discount Rate Definition

Discount rate, defined also as hurdle rate, is a general term for any rate used in finding the present value of a future cash flow. In a discounted cash flow (DCF) model, company value is estimated by discounting projected future cash flows at an interest rate. This interest rate is the discount rate which reflects the perceived riskiness of the cash flows.

Discount Rate Explanation

Using discount rate, explained as the risk factor for a given investment, has many benefits. The purpose of discount rate is to account for the loss of economic efficiency of an investor due to risk. Investors use a discount rate because it provides a way to account and compensate for their risk when choosing an investment. This provides, with each choice, a buffer to provide for the chance of failure in an investment over time as well as many investments over a portfolio. Though risk is somewhat of a sunk cost it is still included to add a real-world element to financial calculations. It is a measure used to prevent one from becoming "calculator rich" without actually increasing personal wealth. In DCF model, there are two methods to get discount rate: weighted average cost of capital (WACC) and adjusted present value (APV). For WACC, discount rate is calculated for leveraged equity using the capital asset pricing model (CAPM). For APV, discount rate, present value, and all else is calculated for all equity firms. The Discount Rate should be consistent with the cash flow being discounted. For cash flow to equity, the cost of equity should be used. For cash flow to firm, the cost of capital should be used.

Discount Rate Formula

A succinct Discount Rate formula does not exist. More, discount rate is included in the discounted cash flow analysis and is the result of studying the riskiness of the given type of investment. Two formulas provide a discount rate: Weighted Average Cost of Capital (WACC) = E/V * Ce + D/V * Cd * (1-T) Where: E = Value of equity D = Value of debt Ce = Cost of equity Cd = Cost of debt V=D+E T = Tax rate or Adjusted Present Value = NPV + PV of the impact of financing

Where: NPV = Net Present Value PV = Present Value

Net Present Value Definition

Net Present Value (NPV), defined as the present value of the future net cash flows from an investment project, is one of the main ways to evaluate an investment. Net present value is one of the most used techniques and is a common term in the mind of any experienced business person.

Net Present Value Explanation

Net present value can be explained quite simply, though the process of applying NPV may be considerably more difficult. Net present value analysis eliminates the time element in comparing alternative investments. The NPV method usually provides better decisions than other methods when making capital investments. Consequently, it is the more popular evaluation method of capital budgeting projects. When choosing between competiting investments using the net present value calculation you should select the one with the highest present value. If: NPV > 0, accept the investment. NPV < 0, reject the investment. NPV = 0, the investment is marginal

Net Present Value Discount Rate

The most critical decision variable in applying the net present value method is the selection of an appropriate discount rate. Typically you should use either the weighted average cost of capital for the company or the rate of return on alternative investments. As a rule the higher the discount rate the lower the net present value with everything else being equal. In addition, you should apply a risk element in establishing the discount rate. Riskier investments should have a higher discount rate than a safe investment. Longer investments should use a higher discount rate than short time projects. Similar to the rates on the yield curve for treasury bills. Other net present value discount rate factors include: Should you use before tax or after tax discount rates? AS a general rule if you are using before tax net cash flows then use before tax discount rates. After tax net cash flow should use after tax discount rate.

Net Present Value Formula

The Net Present Value Formula for a single investment is: NPV = PV less I Where: PV = Present Value I = Investment NPV = Net Present Value

The Net Present Value Formula for multiple investments is:

The sum of all terms of: CF (Cashflow)/ (1 + r)

t

Where: CF = A one-time cashflow r = the Discount Rate t = the time of the cashflow

Definition Internal Rate of Return

The Internal Rate of Return method is the process of applying a discount rate that results in the present value of future net cash flows equal to zero. This is the base internal rate of return calculation formula and will be described later in this wiki. Internal rate of return assumes that cash inflows are reinvested at the internal rate. Investment projects with a return greater than the cost of capital or hurdle rate should be accepted. The greater the internal rate of return the more attractive the investment. Below is the IRR hurdle rate comparison. IRR > hurdle rate, accept the investment IRR < hurdle rate, reject the investment IRR = hurdle rate, the investment is marginal The internal rate of return meaning is described in more detail below.

Internal Rate of Return Explaination

Internal Rate of Return is a method to compare and evaluate different investments based on their cash flows. A proper internal rate of return calculation provides an interest rate equal to the total gains expected from a given investment. After discovering the internal rate of return for one project other IRRs can be compared in order to find the most valuable investment choice. Additionally, one compares an internal rate of return to the weighted average cost of capital of a project to decide whether the investment will create profit. IRR also accounts for the time value of monitary gains. It is generally used to evaluate a series of cash flows but can also be applied for other needs. Many equity investors, including angels and venture capitalists, have a required rate of return which must be met or exceeded by the IRR of a company seeking investment. This ensures the investment warrants the associated risk and will provide the cash flows necessary for profit.

Internal Rate of Return Formula

The internal rate of return formula can be found algebraically by using the Net Present Value formula below. In this: NPV = (CF 1 / (1 + r) ^1) + (CF 2 / (1 + r)^2) + (CF 3 / (1 + r) ^ 3) + ... Where: NPV = Net Present Value CF 1, 2, or 3 = Cash flow in period 1, Cash flow in period 2, Cash flow in period 3, etc. r = The Rate of Return

The rate of return (r) for which NPV = 0 is the internal rate of return calculator. So, if: 0 = (Cash flow in period 1 / (1 + IRR) ^1) + (Cash flow in period 2 / (1 + IRR)^2) + (Cash flow in period 3 / (1 + IRR) ^ 3) + ... Where: NPV = Net Present Value CF 1, 2, or 3 = Cash flow in period 1, Cash flow in period 2, Cash flow in period 3, etc. IRR = Internal Rate of Return

Basic Economics for Capital Budgeting Analysis

Planning for capital assets involves a process of calculating the Net Present Value of the investment. Net Present Value is calculated by discounting the future changes in cash inflows and cash outflows using the weighted average cost of capital. The resulting present value of cash flows is compared to the Net Investment for the Capital Asset. The result is called Net Present Value. It should be noted that Net Investment includes all costs to place the capital asset into service plus any working capital requirements. If the capital asset has above average risks, than we would increase the weighted average cost of capital. If the Net Present Value is positive, this indicates that value is added by making the investment. If the Net Present Value is negative, this indicates value destroyed. The objective is to have a total asset portfolio where the total Net Present Values are above zero. Besides Net Present Value, we can use Internal Rate of Return and Discounted Payback Period to evaluate capital projects. Internal Rate of Return is the rate of return that the project earns. It is calculated by finding the discount rate whereby the total present value of cash inflows equals the total present value of cash outflows. Modified Internal Rate of Return can be used to remove the assumption that funds are reinvested each year at the Internal Rate of Return. We can also calculate the number of years it takes to recoup our Net Investment. Simply calculate a running total of the discounted cash inflows to determine the Discounted Payback Period. Net Present Value, Internal Rate of Return, and Discounted Payback Period are three popular economic criteria for evaluating whether or not to invest in a capital asset. All three concepts give consideration to the time value of money. Estimating incremental cash flows is one of the most difficult steps in the overall evaluation process.